Goldman's "Naked Short Selling" Strawman

Matt Taibbi has put together a very informative piece on Goldman's lobbying attempts, specifically in the context on the upcoming discussion over naked short selling. The contention here by the majority is that naked short selling, or NSS, promotes bear raids on crippled companies which tend to feed upon each other, with CDS traders also joining in the fray. The argument is a dramatic oversimplification and has little substantiation by facts. "Bear raids" occur only and exclusively in financial stocks: why can't you have a bear raid on a firm like Coke or Johnson and Johnson, or even some leveraged behemoth like Hertz.

As an side, full disclosure before Hertz sues us like it did Audit Integrity for daring to mention that it is a prime bankruptcy candidate: we fully recognize the company's tremendous cash flow potential, its amazing assortment of non-rapidly amortizing fleet vehicles, it manageable capital structure, its absolute lack of reliance on pristine credit markets, and the fact that GM is now entering the rental arena courtesy of GM's 60 day money back guarantee is only a synergistic positive: after all the definition of fleet sales is completely irrelevant for a post-bankruptcy Detroit 3 monster. Hertz is a titan of a company and its prospects foreshadow a future so bright we've gotta wear shades.  Zero Hedge however feels for third party research companies like Credit Sights, GimmeCredit, or KDP which may feel otherwise. We hope Hertz' legal team smites them like the irresponsible cockroaches they are if they ever dare to issue a negative report on such a stalwart of American Kapitalism.

Anyway, back to the original point - if you do a bear raid on a company that has tangible assets all you end up creating is an attractive entry point for others who see the depressed stock price as an indication of cheap valuation and nothing else. Of course, why this could be a threat for financial firms, is that the vast majority of financial companies are woefully undercapitalized through the equity level. Bear raids can in fact work when there is a total loss in confidence in any one company. Ironically what worked with Lehman, if indeed it was a bear raid, could easily, and almost did, work with virtually all other financial companies whose only tangible assets were a cesspool of toxic loans whose value is nickels on the dollar. This of course, before Hank Paulson decided to replenish their balance sheets directly via TARP hot-capital injections. That their core balance sheet exposure hasn't moved a smidge is irrelevant, yet could explain why a financial company like Goldman, which for all intents and purposes is in much better shape than all of its peers, could nonetheless be concerned about what happens the proverbial next time around.

Yet what is most relevant here is the presentation that accompanies Goldman's lobbying efforts, which underlines the straw man nature of NSS. In isolation NSS is mostly a bogeyman to the next generation of Dick Fuld's. However, when viewed in the context of all other salient points on the "market structure debate" (a term coined by Goldman) it does become a much more relevant issue. After all, NSS is a critical cog in a properly functioning, computer traded landscape, which as we have been discussing for a long time, is now dominated by such concepts as High Frequency Trading, and where a majority of trading occurs under the radar in dark liquidity pools, potentially using trading proxies such as sponsored access.

From the Goldman presentation obtained by Taibbi:



Notable here is that even as Goldman is presumably extolling the virtues of NSS (a topic which we will discuss much more in depth at a later date), the key considerations presented relate to:

  • "Dark Pools" & Reg. ATS
  • High-Frequency Trading & Exchange Collocation
  • Sponsored Access/DMA
  • Flash Trading & IOIs.

What is curious is the melange of various represented conflicts within this structure debate, that Goldman is either pro or against. On one hand the firm is against lowering of Reg ATS Fair Access thresholds, which would enforce quote obligations, thus dramatically lower the volume of traded stocks on dark pools before the transactions need to be disclosed, yet on the other hand Goldman is for declawing actionable IOIs, a critical component of dark pools, and the equivalent of Flash orders in traditional exchanges. As an aside, and to highlight the growing divergence of opinions on these matters, even as Goldman is against threshold reduction, the head of Credit Suisse's Advanced Execution Services group has a diametrically opposite opinion: "Lowering the threshold appears to be on the table," he said. "We're thrilled the SEC is reviewing this issue. We're hopeful they're going to make a change." In essence, this would be a categorical first step to pushing dark pools into the gray, and subsequently open, arena:

"This would be a radical change," [Jamie Selway of White Cap Trading] said. "If you're a dark pool of reasonable size and you're exchanging order information through what are essentially limited private networks, you'd incur quote obligations. That would probably kill the practice of routing out order-ish messages." He added that dark pools would have a harder time going "semi-light" to pursue more executions.

Goldman is reticent on the topic of Sponsored Access, even though it is a core provider of such services to its clients. As readers may recall, Zero Hedge highlighted some quotes from Greg Tusar previously which indicated the firm's hesitancy on DMA. Yet is this merely an altruistic attempt to curry favor with regulators? One could argue, that Goldman, under the administration's protective wing, is simply trying to redirect the bulk of DMA order flow to its own product offering. If so, this would become evident once new formal DMA rules are set in place, which, magically put Goldman in absolutely no violation of new statutes, while other DMA providers have to scramble to not lose their existing customer base. And what happens if you attain DMA monopoly, or if for some reason, there is a fatal error in order flow especially if post-trade monitoring is enacted as the defacto standard? We quote Lime brokerage:

With a two minute delay to cancel these erroneous orders, 120,000 orders could have gone into the market and been executed, even though an order validation problem was detected previously. At 1,000 shares per order and an average price of $20 per share, $2.4 billion of improper trades could be executed in this short timeframe. The sheer volume of activity in a concentrated period of time is extremely disruptive to the process of maintaining a “fair and orderly” market. This shortcoming needs to be addressed if the practice of Naked Access is going to be permitted to continue; otherwise, the next “Long Term Capital” meltdown will happen in a five-minute time period.

Lastly, on the topic of HFT and collocation, Goldman is again donning the sheep's clothing and pretending to be all for fair use: "Additional trading obligations should be attached to the privilege of co-location and special rebates offered by exchanges." Funny this should come from Goldman, which has attained a virtual monopoly in both of thsee verticals. And pray tell, dear Goldman, just what obligations will these be? Would they happen to be permissive to Goldman, which, as it just so happens, has a balance sheet perpetually guaranteed by taxpayers, and thus can assume any risk tolerance thresholds, yet virtually unattainable by the incipient competition?

In this cluster of various market landscape artifacts, one can see why NSS is a key issue: any change in its existing form would disrupt an infrastructure that is geared toward instantaneous trade flow, not only on the upside, but definitely to the downside as well (and if you think the market can only go up, you are in for a surprise). Obtaining pre-clearance, or complying with other forms of NSS curbs would be a major stick in Goldman's well-greased PT/SLP/HFT machine, which desires nothing else but to simply solidify its monopolistic position in equity markets. We hope the SEC, other regulators, and politicians can see beyond this thinly veiled attempt by Goldman to promote its own ever-more-dominant interests in the "market structure debate" and not to be caught up on the NSS strawman which is nothing more than a critical part of modern markets used and abused by those who already have an unprecedented, monopolistic presence in virtually every realm of equity trading.